The Psychology of Trading

by Brett N Steenbarger

  John Cutting's work showed that there is a division of labor within the brain between centers that process self-relevant, emotional information and those that process patterns in the world around you. When one hemisphere is activated, the other tends to be suppressed. This can catch you in highly emotional states where it is difficult to identify and act on market patterns. By immersing yourself in nonemotional processing, such as meditation, self-hypnosis, or repetitive tapping, you suppress and dampen your emotional processing. This builds a sense of control and reinforces your Observer. With sufficient repetition, it is possible to enter highly focused, nonaroused states in a matter of seconds, dampening feelings of anxiety, self-doubt, and overenthusiasm.

  2.Shifting out of old patterns by making radical leaps. A second set of methods for altering unwanted patterns of arousal involves making radical shifts in your behavior patterns. These "leaps" or "gearshifts," as I have referred to them, push you beyond your normal comfort zones to alternate mental, emotional, and physical states. Once in these states, it is possible to process information about yourself—and about the market—in new and potentially more constructive ways. If I am feeling discouraged and burned out, for example, I may undertake particularly strenuous and extended physical exercise to pump up my mind and body. Conversely, in a state of anxiety, I will pull away from the screen and engage in a prolonged biofeedback session in which I must remain completely still and bring my physical arousal to unusually low levels.

  Such shifts enable people to access previously hidden modes of thinking, feeling, and acting. I have repeatedly observed peak-performing athletes provoke fights on the field, pumping themselves up in the process. Coaches, similarly, will incite their players with confrontations and tongue-lashings. I showed you how Dave was able to become enraged at his patterns of negative thinking, fueling his efforts at passing the exam. When you leap to a new mind state, you not only abandon the patterns associated with the old state, but also activate new potentials.

  The act of radically shifting to another mode may be more significant than the specific mode to which you shift. The extraordinary act of effort required to achieve a breakaway from the gravity of your habitual states confers its own momentum. The ascetic acts associated with many of the world religions make sense in this context. When people renounce worldly pleasures, they make a supreme effort that allows them new access to states of mind and spirit. It is not by coincidence that monks seek the Almighty amidst avow of silence, that nuns achieve a commitment to Christ by renouncing conjugal relationships, that Jews fast to achieve a state of atonement, or that Buddha found enlightenment after days of solitude beneath the tree. Extraordinary efforts are required to sustain extraordinary departures from normal functioning.

  Although some radical leaps involve shifting to polar extremes of experience, such as jumping into a tub of freezing water when one is feeling bored and lethargic, other leaps are achieved by blasting through emotional reactions already present. In a sense, this variation of the gearshift strategy is the opposite of the first, dampening approach. For a person who is feeling anxious and uncertain, for example, the goal is to accentuate this experience by entering more deeply into it. This can be accomplished through the use of imagery, enacted role-plays, the reexperiencing of dreams, and so on. Therapists such as Alexander Lowen and Alvin Mahrer have found that, once immersed in this heightened experience, people undergo a transformation to a new state and understanding. The anxiety over a volatile market, for example, may give way to expressions of anger, as prior losses are recollected and reexperienced. In expressing and making sense of this anger, the trader diminishes much of the prior fear.

  From this perspective, blocking your emotional responses, rather than the responses themselves, may be the greatest obstacle to effective trading. Many times these blockages are maintained physically, as chronic muscle tensions and physical inhibitions. This is why some of the most effective strategies for deepening your experience involve the achievement of new physical behaviors and states. In freeing your body and allowing yourself to fully experience fear, frustration, greed, and overconfidence, you can break through to the opposite side, where these feelings no longer control you. Not infrequently, people are afraid of making the effort needed to fully experience themselves because they tacitly believe that they will become overwhelmed in the experience. Actually blasting through a negative emotional state provides a powerful affirmation of one's trance-formative capacities.

  Such bursts of effort, to new states or through existing ones, may not resolve the particular issues creating one's state of mind—if, say, my poor juggling of home and trading responsibilities are burning me out. The shifts, however, can break self-destructive loops in time to salvage a trade. Moreover, you may be pleasantly surprised to find that it is easier to address those outstanding personal issues once you have switched mental and emotional gears. In general, the unwanted behavior patterns that affect traders are either inhibitory (problems in pulling the trigger) or excitatory (problems with impulsive trading). By making strong physical and emotional efforts during periods of inhibition and strong efforts at self-control in times of excitation, it is possible to quickly exit these modes before they intrude on trading.

  3.Cultivating new behavior patterns. This group of strategies seeks to develop positive action patterns, rather than to dampen or exit old, maladaptive ones. It is grounded in the recognition that, usually, there are exceptions to problem patterns in which you act in highly constructive ways. These solution patterns can form the foundation for change efforts, as you enact more of what is already working for you.

  The first step in enacting this solution-based strategy is a different kind of self-observation. It is necessary to observe what you are doing right: what is working. This is where an audit of your trading can once again prove useful, focusing on trades that have been well executed. (Note again that well-executed trades are not necessarily the most profitable ones. It can be very useful to audit trades in which you have successfully cut losses short, for example.) Such an audit is best taken from a trading journal in which you have carefully noted the reasons for making each trade, your thoughts and feelings at the time of placing the trade, and the outcome of the trade. Very often, such a journal will reveal patterns among the positive trades that otherwise would escape your attention.

  You may find, for instance, that trades based on particular market configurations are especially profitable. Such was the case when I reviewed the minute-to-minute action of multiple sector indexes at the time I placed short-sale trades. A pattern that became evident was that short trades placed at times of multiple divergences among the indexes (some making daily highs; others falling x percent short of their daily highs) tended to be more successful than trades placed when a greater proportion of indexes were at or near their highs. This trading pattern thus became one that I wanted to internalize as part of my strategic repertoire.

  Anchoring such a solution pattern to a distinctive state—a unique cognitive, physical, and emotional mode—can greatly assist its internalization. People achieve most distinctive states by either greatly reducing or increasing their normal level of arousal. Meditation is an arousal-reduction strategy; physical exercise can be used to heighten arousal. I have found pacing continuously around my house while verbally rehearsing my new trading strategies and scenarios to be especially helpful in building positive action patterns. Others with whom I have worked have benefited by mentally rehearsing strategies in states of self-hypnosis or in the highly aroused states achieved during physical workouts.

  Discovering the anchors that work best for any particular trader is, to a large degree, a matter of trial-and-error. It is especially important that your subsequent trading be performed in the same state you have been rehearsing while invoking the solution patterns. I do not want to be trading while sitting silently at my station for hours if I have been rehearsing solutions while pacing and talking. I am much more likely to successfully ident
ify and to act on the solutions if I am processing the market while pacing and talking out what I am seeing. Indeed, I have found that often I can see what the market is doing only after I have spoken it aloud during my stream of consciousness processing while pacing. Looking at charts and data provides the raw material for processing, but integrating the information into meaningful patterns sometimes only occurs once I have shifted to another mode.

  The solution pattern you rehearse may be a pattern in the market data, as in my example in the previous paragraph, or it may be one of your own behavioral patterns, as in the case of rehearsing the ability to stop a losing trade or let a winning trade run. Anchoring works by simple classical conditioning. By repeatedly pairing a desired pattern with a distinctive state of mind or physical state, you become better equipped to identify and to act on that pattern whenever you invoke that state. What you see and how you construe information is dependent on the state you are in. By practicing constructive behavior patterns in a unique state, you gain control over the subsequent enactment of those patterns.

  Sometimes traders are unable to identify their own solution patterns. In such cases, all is not lost. A powerful strategy that relies on the same logic is to extract those solution patterns from a mentor and then systematically anchor them to a distinctive state and become the play-actor of those ideals. If I learn a trading pattern from a teacher, for example, I might rehearse this pattern repeatedly by placing myself in a state of intense focus and concentration and then reviewing the manifestations of the pattern in my historical data. I will activate this same focused state and paper trade the pattern in real time, before actually undertaking small trades with the strategy. Through this repetition and anchoring, the role-played trading method begins to feel more natural and eventually is internalized as part of my repertoire. The simple act of focusing oneself can then aid in recruiting the trading method.

  Most of the change efforts you will undertake in the markets will boil down to one of these three strategies. You will either be attempting to dampen unwanted reactions, leap to discrepant states and patterns, or cultivate novel, positive ones. There are many, many variations on these strategies and an infinite number of creative ways of putting them into practice. Ultimately, however, their success is contingent on the quality of your self-observation at the outset—pinpointing the changes to be made—and the extent of rehearsals once the change efforts have begun. Very often people are successful in initiating change but not in sustaining it. Performing exercises many times on a daily basis and performing them in the same way each time greatly facilitates consolidation.

  And that leads to the most powerful trading psychology strategy of all: having friends and family that are supportive of your efforts at self-development. In pursuing aims with extraordinary effort, you are not leading a normal life. This calls for remarkable understanding from those around you. Normal people do not stay up for hours at a time at night, typing automatic thoughts on a keyboard. They do not stay connected to biofeedback and sound-and-light machines while trading or processing market data. For others to not only tolerate but also value this departure from normality is rare and special. Whatever insight and experience I have captured in this book could never have been achieved in the absence of supportive family, mentors, and colleagues.

  MATCHING YOUR TRADING TO YOUR PERSONALITY

  One of the most profound pieces of market wisdom I have ever encountered appeared in an article by Linda Bradford Raschke. She advised beginning traders to focus on one or two tested market patterns and simply trade these. If you have done your homework, these patterns by themselves should provide you with a decent living. The patterns you will trade will depend on your approach to the markets, which, in part, will be shaped by your personality and your financial goals.

  After having surveyed a number of frequent traders with Linda, I came away with two impressions regarding trading and personality:

  1.Many traders who report emotional problems in the market are experiencing difficulties because their trading is understructured. By this I mean that they have not carefully defined the patterns that trigger their entries and exits and often lack explicit mechanisms for money management. I do not at all believe that all traders need to trade mechanical systems, but I would say that the majority of distressed traders I have encountered would benefit from becoming more rule-governed. The best educational services I have seen for traders, including Linda's, limit themselves to a core group of tradable patterns that have been tested. These services then remain faithful to their methods. When traders lack this structure and discipline, it is very difficult for them to internalize confidence. Their trades are particularly vulnerable to emotional intrusions and occasional debilitating losses. Rules go a long way toward keeping traders reality grounded.

  2.Many traders who report emotional problems in the market are experiencing their difficulties because they have not found a good fit between their trading styles and their personalities. Tolerance for risk is, in part, a traitlike personality variable. When traders with low tolerances for risk expand their holding periods, they are going to be particularly vulnerable to the enhanced drawdowns that come with the territory. Similarly, a trader with a visual, intuitive learning style may find it difficult to stick with a mechanical trading system. Many traders I have surveyed or interviewed have methods or systems that they want to work, but they have not asked the hard questions as to whether these methods or systems are ideal for them. As a therapist, I am accustomed to processing subtle markers in my interactions with people. It is not surprising that my best trading makes use of this skill. When I have attempted to trade in other styles—especially mechanically—the results have been poor. I simply cannot trade something I do not feel and perceive firsthand. Conversely, my good friend and successful trader Henry Carstens is a marvel at developing trading systems and, I strongly suspect, would find it very difficult to trade in a discretionary manner. The issue isn't so much one of which approach to trading is best. Rather, it is important to find the proper fit between the trader and the trading.

  I strongly suspect that some people have personalities that simply are not well suited to trading. Not everyone possesses the necessary blend of flexibility and analytical decision-making skills. Similarly, not everyone possesses the requisite emotional maturity and self-discipline to become a successful trader, just as not everyone possesses the skills to be a world-class basketball player or surgeon. From the limited data Linda and I collected, I would say that trading will be an uphill battle if you are generally prone to high degrees of emotional distress (anxiety, depression, anger) and if you tend to be impulsive, poorly disciplined, and not particularly conscientious in everyday life.

  True, there may well be emotionally volatile, undisciplined traders making a fortune in the markets. I must say, however, that the ones I have observed have not kept their fortunes. To a person, the successful traders I have observed have been methodical and highly rule governed. I believe a careful reading of Jack Schwager's Market Wizards books supports this conclusion. The methods and the rules differ for various traders—some are scalpers, some are swing traders; some are more discretionary: Some are more mechanical. All of them, however, appear to have plans and techniques that they have observed and researched exhaustively, honed carefully, and implement faithfully. These plans and techniques are extensions of their personalities, capturing the distinctive ways in which they process information and handle risk and uncertainty.

  THE GREAT FRONTIER: DEVELOPING TRADING EXPERTISE

  A review of research convinces me that the greatest strides in the psychology of trading will come not from psychotherapy, but from the field of learning. Recent developments in cognitive neuroscience suggest that learning—like emotional change—can be accelerated under the proper conditions. This has profound implications for the training and development of traders.

  The implicit learning research of Arthur Reber and Axel Cleeremans indicates that people acquire
complex skills such as spoken language long before they are capable of verbalizing the rules of spoken language. Their knowledge is tacit or implicit, held at a level beneath explicit verbalization. A series of clever experiments utilizing artificial grammars—strings of letters that are combined by sets of rules—indicates that such implicit learning is not at all uncommon.

  Pretend that I have invented an artificial grammar that follows this pattern: UFMAG. I will flash those five letters, one by one, to the participants in the experiment. Every time I flash the letter "U," it will be followed by an "F." Each time I display the letter "A," the next letter will be a "G," and so on. It is relatively simple to create grammars of varying complexity by altering the number of letters in the grammar and the rules that govern the letters' appearance.

  The key to the experiment is that the subjects are not told the underlying rules of the grammar. They are first shown strings of letters that are grammatically and ungrammatically formed (i.e., that follow or don't follow the rules) in an acquisition phase. Then, in a testing phase, they are asked to determine whether presented strings of letters are grammatically formed. Subjects are corrected when they get an item wrong, but they are not informed why they were wrong. They then move quickly on to the next item. This occurs over a large number of trials.

  Over time the participants become quite adept at determining whether the strings of letters are grammatical. They seem to pick up the pattern that underlies the grammar. If, however, you ask the participants to state their reasons for determining the grammaticality of the strings, they cannot verbalize the rules. Indeed, they often insist that the patterns were random and that they were merely guessing well. Their learning appears to be implicit in that they know something but don't necessarily know that they know it.

  In his book Implicit Learning and Tacit Knowledge, Arthur Reber pointed out that subjects are capable of learning even highly complex grammars under noisy conditions. For instance, in one set of studies, participants were asked to predict the appearance of an event, a flashing light. The appearance of the event on any trial N, however, was dependent on what had occurred at trial N–j, where j was varied between one and seven across trials. Surprisingly, participants were able, over time, to predict the appearance of an event based on what had happened many trials ago—again without being able to verbalize the basis for their predictions. Moreover, when a noise element is added to the acquisition phase, in which a varying percentage of the elements presented to participants are randomly derived, implicit learning still occurs.